Politics

FINRA Supports Regulation to Quell Competition

The financial services world is split between investment advisers and broker-dealers.

Investment advisers are legally required to act as fiduciaries. They must subordinate their interests to those of their clients. Should a conflict of interest arise, they must either eliminate it completely or fully disclose it to their clients.

Broker-dealers, in contrast, are regulated by a loosely defined “suitability standard.” They are agents of a brokerage firm first and obligated to act primarily for its benefit. Massive legal disclosures handle their many conflicts of interest.

Process governs the broker-dealer. A signed disclosure is sufficient to meet regulation.

The investment adviser is governed by principles. Every action must be in the best interest of the client.

Broker-dealers generally become members of the Financial Industry Regulatory Authority (FINRA), a private self-regulatory organization. Both investment advisers and broker-dealers must register with the Securities and Exchange Commission (SEC).

The SEC is a federal agency that oversees the entire securities sector including investment advisors, broker-dealers and FINRA.

What makes the financial sector even more confusing is that some registered representatives of broker-dealers also register as investment advisor representatives (IARs). This strange breed of financial professional must submit both to the fiduciary standard of care mandated by the SEC and to the obligations and interests placed on them by their brokerage firms. Many fail at this bizarre balancing act.

According to SEC commissioner Daniel M. Gallagher, these broker-dealers have poor compliance records with 20% having to disclose one to five items “such as customer complaints, regulatory violations, terminations, bankruptcy, judgments and liens.” At the firm level, 17% of broker-dealer firms have more than 6 of these negative marks; 5% of broker-dealer firms have over 20.

The other 12% of IARs, however, are investment advisors who are independent of any broker-dealer. And fewer still belong to the National Association of Personal Financial Advisors (NAPFA), a private organization that imposes an even stronger fiduciary standard than the SEC. Their high standards are incompatible with the broker-dealer way of operating. Less than 1% of investment advisers are members of NAPFA.

For years, the SEC agreed. It wisely focused its reviews on the 5% of broker-dealer firms, and those with the most risky financial practices.

However, FINRA and Commissioner Gallagher have called for a change. They have proposed three so-called solutions, but each punishes well-behaving fee-only fiduciaries and benefits FINRA member firms.

The first suggestion is to ask Congress to impose fees on non-FINRA firms so the SEC can inspect them more frequently.

SEC registration already carries a bill, but this proposal adds an additional fee at the time of the SEC’s visit. Imagine if the police made you pay a fine every time they interacted with you regardless of your guilt.

Large broker dealers have an entire department of lawyers to handle their compliance paperwork. For them, compliance issues only make up a small percentage of their operating overhead.

Even if FINRA were to evenhandedly oversee fee-only fiduciaries, their rules-based transaction mindset of written disclosures is simply not the right one for fiduciaries who put client interests first.

We should be suspicious of firms that invite government regulation into their own industry. When government regulation is requested, it is often an attempt of one industry model to quell its competition.

We believe the ability of some firms to distinguish themselves in the free market is an important freedom to preserve. The trend among investors has been to continue the migration away from commission-based agents and broker-dealers toward fee-only fiduciaries. Keeping nonbrokerage advisors independent from FINRA is critical to this distinction.

The third proposal would require everyone in the financial services industry to be subject to a fiduciary standard including those currently only subject to a suitability standard.

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)